The Multi-Dimensional Concept of Insolvency

Corporate and personal insolvency law

The world of corporate and personal insolvency law is festooned with large volumes full of academic debate on issues such as the misconduct of directors prior to insolvency, the meanings of wrongful trading, transactions at undervalue, the role of the liquidator and the ideas of turning a business a round. However a studied reading of the literature shows a distinct lack of attention towards the very concept around which the whole area of law is built, namely insolvency. This is precisely why it is such an interesting subject; the field is relatively unspoiled as far as academic debate within the United Kingdom^[1] is concerned. In this work I intend to set out the key areas of controversy that surround a determination of insolvency and at the very least give this exciting field of law a bit more structure and depth. I have concentrated on corporate insolvency but as Tolmie’s^[2] book shows in determination of insolvency there is very little distinction between personal and corporate insolvency.

The Multi-Dimensional Concept of Insolvency

A debt can be simply defined as a something that is owed by one person to another; correspondingly Insolvency should be capable of definition simply as the situation where one person does not own the assets to be able to give back what is owed to that other person. Perhaps this is the mindset of many of the commentators that the situation is so straightforward that it hardly requires attention in a legal sphere. However, as has been stated in accountancy spheres:

‘It is a common feature of such concepts that there is seldom any difficulty in understanding what they mean but frequent controversy over their application to particular facts…because such concepts represent a very high level of abstraction…there can never be a sharply defined line’^[3]

What has to be primarily kept in mind when dealing with determinations of insolvency is that it is not a legal concept as such, it is more clearly to be understood as an objective set of facts to which the law may or may not attach consequences. The further confusing attribute of insolvency is that the set of facts to which legal consequences could be attached is not static enough to give a definitive and unified concept of insolvency. It is well established however that the existence of any of the sets of facts at any one time does not by virtue of its existence entail legal consequences^[4]. To give an idea of this multi-dimensional nature of the concept of Insolvency in law a few examples will be necessary. The concept of insolvency is understood to operate in various forms within the Commercial Law sphere for example in proceedings for winding up^[5], insolvent liquidation^[6], the setting aside of transfers at undervalue or preference^[7], in relation to disqualification of a director^[8], entitlements for an employee to payments from the National Insurance Fund and many others that is why the whole area of law concerning winding up and liquidation is known as Insolvency Law. The concept of Insolvency is the bedrock of the whole subject area however looking beneath the surface we can see that really the single name belies a multi-dimensional reality or what Goode described as the ‘bewildering variety’^[9]

A prime example of this multi-dimensionality can be seen for example in the distinction between Insolvency in relation to disqualification of a director and for purposes of winding up. In the case of the former, s.6 (2) of the Company Directors Disqualification Act 1986 governs what insolvency means in this issue and is defined as insolvent if ‘it goes into liquidation at a time when its assets are insufficient for the payments of its debts’^[10]. However in relation to winding up there is very similar ‘balance sheet test’^[11] but also a ‘cash flow test’ that describes insolvency as the inability of a company to pay its debts as they become due^[12], this has no necessary logical connection to the weighing of assets and debts and there is no rationale for its use in one but not in the other. A further problem is that s.6(2) uses the term ‘debts’ and not the term ‘liabilities’ which is used in the Insolvency Act 1986^[13], a distinction which could be of significance. Another discrepancy is to be found within the IA 1986 itself in relation to insolvent liquidation whereby the balance sheet test is used^[14] on its own but in a petition for winding up, as was mentioned above, this test is used in conjunction with the cash-flow test. Whilst it may be possible to make an argument based on cross-legislation coherence that in fact insolvency was a unified concept, for example in the previous example of s.6 (2) the requirement of going into liquidation may mean in essence that the provisions of the IA are used in any case however this is not really an acceptable answer and begs the question why have duplication of the tests? It would be simple enough to just make reference to the IA, the act which was supposed to update and modify the rules on insolvency to reflect contemporary attitudes^[15] and is generally the central act in insolvency law.

It must be remembered that the reason for the foregoing critique of the multi-dimensional nature of insolvency is to highlight that in discussing the problems surrounding determinations of insolvency we have to have some sort of standard against which to measure, in my estimation this standard has to be two-fold. We must measure them against the general aims of law and also the specific aims of Insolvency law. The law is generally liberal in nature; it is embodied in principles such as the rule of law and requires being definitive, specific and non-intrusive so as to allow citizens the maximum amount of freedom under a system of laws. This liberal ideology certainly seems to have failed in respect of the multi-dimensionality of insolvency, the lack of one clear definition in one statute we have many slightly differently worded across many different statutes. In reference to the liberal aim of law therefore this multi-dimensionality is definitely a problem.

We don’t have the space to have a thorough discussion of the different views on the jurisprudential role of insolvency law in society but definitely a broad understanding will help us critically review the current state of the law as regards determinations of insolvency^[16]. The dominant theories all place the emphasis on creditor rights and security, whilst certain theories such as the communitarian theory^[17] place the emphasis on all those potentially effected such as members of the public, managers, employee’s &c… even in these the emphasis is seen on controlling and rationalising the insolvency procedure so as to reduce the potential harms of insolvency. What does this highly broad theoretical base tell us about determinations of insolvency? I would primarily argue that the prevention of harm would be best served by what the Cork statement defined as a ‘framework of insolvency law’ that is ‘simple and understood’ as well as ‘free from anomalies and inconsistencies’^[18]. Therefore I will be analysing all such ‘anomalies’ and ‘inconsistencies’ in this field and with respect to the preceding deem them as falling short of the aims of insolvency law as a whole.

S.123 IA 1986

Both Goode^[19] and Finch^[20] agree that the basis of Insolvency law is the inability to pay debts; this to all extents appears to be a broad truth upon which we can agree as a determining feature of insolvency. The starting point for any investigation of determining insolvency has to be found in s.123 (1) (e) and (2) of the IA 1986. The former is commonly known as the ‘cash flow test’ and the latter as the ‘balance sheet test’. S.123 is the single most important test in corporate insolvency, it is the threshold that creditors wishing to access winding up procedures, administration orders, setting aside transactions at undervalue, preferences and floating charges must satisfy.

Cash Flow Test

The Cash Flow test contained in s.123 (1) (e) is a fairly generic provision with international insolvency regimes. Where the situation arises that a company is unable to pay debts as they fall due, this has nothing to do with assets, this probably goes to our common sense understanding of insolvency as a general inability to pay debts. However, it is well worth noting that it is distinct from this; the case of Re European Life Assurance Society^[21] laid down the principle that in applying this test the word ‘unable’ denotes a day to day basis whereby ‘it is immaterial…that the company could pay all its debts over a lengthy period by steady realisation of all its assets’^[22]. Evidently the test is concerned with a testing of the status quo and as a corollary to this aim there is absolutely no contemplation of future or contingent liabilities. These are liabilities that may or will become due in the future; it is only concerned with the current debts that have become ‘due’. However, the court does not apply this view with over strictness and will have obvious regard to whether or not the ability to pay debts is merely temporary^[23]. This test is clearly in line with the general prevention of harm principle that underlies insolvency law, if a company is unable to carry on its day to day business and pay its creditors on time then it is doing damage, as Marshall puts it ‘What a creditor is primarily concerned with and entitled to in commercial transactions is to receive payment when it is due’^[24]. This perhaps explains its universal appeal, in Scotland the cash flow test is embodied under the concept of practical insolvency, it is also to be found as formulated in the Sale of Goods Act 1979 s.61(4), it is used in many major developed and developing economies in areas like Indonesia and Singapore^[25], it is incorporated in s.95A of the Corporations Act 2001 in Australia, Title 11 – Chapter 3 – Subchapter1 – Subsection (h) (1) of the US Bankruptcy Code endorses the cash flow tests in America.

Balance Sheet Test

However, just to confuse the issue the IA 1986 institutes a complementary test for insolvency^[26] commonly called the ‘Balance Sheet Test’. This test is more technical and accountancy based than the cash flow test. As classically stated balance sheet insolvency occurs where the company’s assets are insufficient to discharge its liabilities ‘taking into account its contingent and prospective liabilities’^[27]. This is the inverse of the cash flow test and quite easily a company could be balance sheet insolvent whilst being cash flow solvent i.e. they are able to pay their current debts as they become due but in light of their future or contingent debts or liabilities it becomes clear that in reality the company simply doesn’t have enough assets to operate and is thus insolvent. It is clear that this test does not have the simple ‘common sense’ appeal of the cash flow test because prima facie if a company is paying its debts it seems somewhat illogical to claim it is insolvent. However, again we can see the underlying rationale of this rule in light of a general prevention of harm to creditors &c… philosophy in that it is clearly not productive to have what is an apparently solvent company, which is trading on the basis of that apparent solvency, attracting creditors, creating employment and generally spreading the net wider as to the people who could be potentially effected by the subsequent insolvency continue to trade when it is inevitable in a longer term view that it will be unable to remain cash flow solvent for the foreseeable future. It is perhaps wise to view this as a test to discover more insidious forms of insolvency that might be exploited by directors with their veil of incorporation. As with the cash flow test the balance sheet test has wide acceptance within the international community, within Scotland this form of insolvency is known as ‘Absolute’ Insolvency^[28], the concept is prevalent in Australia^[29] and the US^[30] however there are notable examples of jurisdictions that do not accept the balance sheet test with open arms such as Thailand^[31] who have rejected its use in the courts a number of times.

Critique of Determination of Insolvency

The foregoing section was meant to give a brief outline of the two most predominant legal definitions or tests for insolvency and in this section I intend to set out a number of issues which highlight the somewhat incoherent and problematic nature of current determinations of insolvency. I have covered the problems at a more abstract level in my section on the multi-dimensionality of insolvency law however this section while also concerned with the lack of coherence and highlighting of inconsistencies takes a much more detailed look at determination problems. The listing of issues is by no means meant to be exhaustive and I’m sure that there are many further problems that will not be covered but these are most certainly the largest problems.

• ‘Unable to pay debts as they fall due’

One of the areas in which determination of insolvency in law seems to have generated the most case law is the situation where a company owes an undisputed debt to another person or company however refuses for their own reasons not to pay. The seminal case in this area is Cornhill Insurance plc v. Improvement Services Ltd^[32]. The facts of the case were such that for reasons best known to them Cornhill Insurance plc had orally agreed with Improvement Services Ltd that a debt of £1154 was owed^[33] however had refused to pay even on petition for winding up. Cornhill tried to argue that it was an abuse of process because quite clearly Cornhill wasn’t insolvent and were in fact a massive financial institution. The court decided on appeal to uphold Improvement’s claim and reinforced the famous dictum of Vaisey, J in Re A Company^[34]:

‘Rich men and rich companies who did not pay their debts had only themselves to blame if it were thought that they could not pay them’^[35]

This seems to be a well settled piece of solvency determination law that unable in fact means exactly the same as unwilling where there are no extenuating circumstances such as a dispute over a debt^[36]. The message is clear therefore from the judiciary that in the case of a winding up petition the law supports the use of the multi-dimensionality of insolvency to enforce debt collection. The blatant disregard for any sort of coherent approach to Insolvency law on a conceptual level can be shown in the case of Re Imperial Hydropathic Hotel Co.^[37]:

‘It was argued that we must be satisfied judicially that the company was in fact insolvent but that is not what the Act of Parliament requires’

It is clear that the multi-dimensionality of insolvency allows it’s to be overlooked as a motivating factor in a courts decision and any pretence at legal certainty or liberal ideals in law is radically undermined because the law does not in fact reflect reality. There are plenty of practitioner articles in fact advocating the use of a winding up petition under s.122 of the IA 1986 as a method of debt collection^[38]. I appreciate that debt collection measures may not be effective however the practitioners and judges have primarily forgotten that law as a liberal institution is meant to set out clear decisive legal rules so citizens can organise their life. As I have discussed above the dominant thinking behind insolvency law is viewing it as a form of protection for society &c… therefore on looking at both liberal aims of law generally and the particular aims of insolvency law that inform that structure how is it possible to justify this use. This does not ‘determine’ insolvency and this is most certainly what inspires the plea by Bragg^[39] that these ought to be a measure of ‘last resort’, however from the point of developing coherence, as was mandated by the Cork Statement , I think this development of the law insolvency shouldn’t be considered at all.

• Quantifiability Problems

The most notable problem with application of the balance sheet test has to be seen as its lack of precision. This problem is textured in a manner because not only are problems of quantifiability an issue but also problems concerning diversions between the legal and accountancy fields that are questionable. A good example of inconsistency between these two disciplines occurred in Tottenham Hotspur plc v. Edennote plc^[40] this concerned the fact the distinction between a finance lease and an operating lease, accountancy distinguishes between the two because in reality there is a vast difference between the rights of control of the lessee under either. However, legally speaking neither are assets of the company because under both the leasor technically is still the owner as defined by property law^[41]. Therefore accountancy ‘balance sheet’ is not necessarily going to be the same as a legal ‘balance sheet’, this could also occur in many other issues such as what is included in the term ‘liabilities’^[42] under accountancy and law. The bottom line is that the judges can decide to take diverging approaches to interpreting the law and where necessary can reject accountancy principles or import them as they feel necessary. There are even more problems in that valuation of assets and liabilities is not a static or necessarily easily issue. It has been identified as one of the problems in Thailand where the expense of bringing a claim under the balance sheet test is exorbitant due to the nature of valuation and its uncertain outcome^[43]. It can depend on numerous things like whether a company is a going concern or not, fluctuations in the market and in the end subjective judgement on the part of the person valuing assets. These problems will not arise in the vast majority of cases because insolvency will be so far advanced as to make the grey areas a non-issue however as the existence of insolvency comes into dispute these grey areas will be magnified and it seems highly unfair that the existence of a company could ultimately turn on what one person, or a select group or persons, believes to be the value of one or two key assets.

• The Open Texture of the Language and Lack of Coherence Between The Tests

As Goode has pointed out^[44], in all jurisdictions and statutes that use the cash flow test in particular there is a general ignorance of the open texture of the particular formulation of the test for determining insolvency. Now this is not going to be a problem in the majority of cases however if we are evaluating against a standard of certainty and coherence ‘most of the time’ is not acceptable. Unfortunately as I have mentioned in my introduction there is a lack of jurisprudence governing the grey areas because determination of insolvency is not a large area of academic debate.

One area in particular where this becomes obvious is in the courts interpretation of the wording ‘as they become due’. The key question is over the temporal nature of the test, as Goode points out, the interpretation of this phrase could be either narrow or broad. In the stricter narrow sense it might refer to debts that existed and required payment immediately. This is the generally understood meaning of the cash flow test, that prospective and contingent debts will not be considered unless the balance sheet test of insolvency is invoked. However, the courts have taken the view that the narrow sense is to restricting and that it is more practicable to take a wider view that reflects a commercial reality rather than adherence to formal application of rules. Therefore courts will look at debts that are going to mature in the near future; this involves a number of subjective legal assessments along the lines of the probability of available funds in the near future and the likelihood of the company being able to pay debts in the near future^[45]. The whole idea is about giving a realistic approach to the determination of insolvency; it is obviously illogical to take the strict approach in interpreting the cash flow test as it would lead to bizarre results such as company that was about to get payment of a massive contract within a few days but previously had been struggling to pay its debts being held to be insolvent. The problem is that for a critical legal scholar this justification of necessity for reality reasons doesn’t suffice as coherent. The concomitant personal liability and shame that can come on directors as a result of insolvency is clearly a sufficient harm that there ought to be clarity over the issue. The ostensibly straightforward nature of the cash flow test belies some highly subjective judgements on the part of the court. Who defines terms such as ‘imminent’ or ‘in the near future’? And more importantly whose ‘reality’ are the judges referring to. This is not the place for a discussion of objective ‘reality’ however it would be sufficiently widely accepted that there is scope for judges and directors to come to a wide variance of opinions on what the commercial reality is. The problem for me as a legal scholar in the liberal tradition of law is that tests such as the cash flow test belie the reality of what’s going on in courts. The test circumvents a wide avenue of debate on whether it is desirable that judges be making subjective judgements about a commercial reality from which they may be wholly removed or ignorant. This sort of test also poses problems from the view of prevention of harm to creditors &c… because it doesn’t give anywhere for them to identify clear rules of insolvency.

However the open texture of the cash flow test is part of a wider problem of incoherence between the two tests. The effect of the courts approach to the cash flow problem and the issue of futurity mean that in reality there is very little difference between the two tests other than length of time^[46]. This has to beg the question that given as Goode puts it ‘there is a close link between cash flow insolvency and balance sheet insolvency in that where a company is a going concern and its business can be sold as such…those assets will have a substantially higher value than if disposed of on a break up basis’. The general idea is that if a company is unable to pay its debts as they fall due then concurrently its assets are unlikely to outweigh its debts and liabilities. However given as has been argued that there is a great degree of independence and interlinking between the subjects on issues such as this and other concerns like quantifying the liabilities and debts involved, as well as the fact that the cash flow test belies a reality of judges applying subjective judgements to cases there is an overwhelming argument for there to just be a general test of insolvency based on commercial reality. Given the lack of discourse on the attractiveness of judges in courts rather than say tribunals with specialists, arbitrating insolvency determinations I will assume that this is desirable. Therefore my previous concerns are overcome because an open concept such as insolvency as defined on a ‘commercial reality’ basis could develop a rich common law basis that has the potential to promulgate more instructive and principled approaches to determinations of insolvency. This view has been expressed in Thailand, where they have rejected the use of the cash flow insolvency test, that such a test would be more readily acceptable and it is clear that Australian Courts are leaning in that direction in more recent times^[47]. The tests separately have significant problems that undermine legal rationality and certainty however they are trying to achieve a purpose but it has to be questioned in respect of the criticisms here brought to light whether there is any rationale for having separate tests. It seems strange that nearly all modern states have approached things in this manner e.g. England & Wales, Australia, US and Scotland. They all show a distinction between the two tests. I have struggled to look for a rationale for the two tests in any of the literature. Now given that there is no established rationale for having two tests surely the weight of the argument has to fall on the side of legal certainty and coherence, an argument which seems clearly to mandate a unitary concept of insolvency with a unitary test fro insolvency to be developed by the courts. I have concentrated on the concept of insolvency as presented in the IA 1986 in the latter half of this work but it must be remembered that other tests for insolvency exist in more specific situations these could all have similar and differing problems to the mainstream ones discussed here. In conclusion, I believe that the UK could jump to the forefront of insolvency law and present a new form of coherent insolvency regulation that is both innovative and revolutionary by implementing a unitary definition of insolvency based around a single test of ‘commercial reality’.

Bibliography

Books

Finch, VanessaCorporate Insolvency Law: PerspectivesCUP / 2002

And Principles

Tolmie, FionaCorporate & Personal Insolvency Law2^nd ed. / Cavendish

2003

Pennington, RobertPennington’s Corporate Insolvency LawButterworths / 1997

Goode, RoystonPrinciples of Corporate Insolvency LawSweet & Maxwell /

1997

Marshall, EnidScots Mercantile LawW.Green / Sweet &

Maxwell / 3^rd ed / 1997

Articles

Goode, RoystonWrongful Trading & The Balance Sheet1989 Jof BL 436

Test of Insolvency

Lightman, GavinAttitudes & Values: Developments In 2002 II 57

Insolvency Law: Part 1

Griffiths, Dan &Creditors’ Winding-Up Petitions1986 Law Society

Griffiths, PRGazette 231

Keay, AndrewThe Service of Statutory Demands on2003 Insolvl 148

Companies

Farrar, J.H.Refusal by a Solvent Company to pay an1986 JofBL 419

Unidsputed Debt

Bragg, RichardObtaining Payment of a Debt by a Winding-Up1986 complaw

Petition162

Internet Articles and Resources

The misreporting of the TPI decision: tests of insolvency – 27 June 2000

http://www.siamlaw.co.th/publications/foijun00.htm

Types of Insolvency

http://www.pattisons.com.au/types.html

www.westlaw.com

www.lexisnexis.com

www.insolvency.gov.uk

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Footnotes

^[1] It is worthwhile noting that jurisdictions such as Australia and New-Zealand have a slightly more rich vein of writing on this subject (see Goode(1997))

^[2] Tolmie (2003)

^[3] Quoted in Goode (1989)

^[4] See Finch, V (2002) p.122

^[5] s.122(1) (f) Insolvency Act 1986

^[6] ss.214(6) and 216 (7) Ibid.

^[7] ss238 – 242 Ibid.

^[8] s.6(2) Company Directors Disqualification Act 1986

^[9] Goode (1997) p.66

^[10] Ibid. p.73

^[11] For discussion of this see below

^[12] Insolvency Act 1986 s.123(1)

^[13] From now on to be referred to as the IA 1986

^[14] s.214 (6) ‘For the purposes of this section a company goes into insolvent liquidation if it goes into liquidation at a time when its assets are insufficient for the payment of its debts and other liabilities and the expenses of the winding up’

^[15] Lightman, G (2001)

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